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Chapter

CAPITAL STRUCTURE THEORY

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Questions while Making the Financing Decision

 How should the investment project be financed?
 Does the way in which the investment projects are financed matter?
 How does financing affect the shareholders’ risk, return and value?
 Does there exist an optimum financing mix in terms of the maximum value to the
firm’s shareholders?
 Can the optimum financing mix be determined in practice for a company?
 What factors in practice should a company consider in designing its financing
policy?

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Features of An Appropriate Capital Structure

 capital structure is that capital structure at that level of debt – equity proportion
where the market value per share is maximum and the cost of capital is minimum.

Appropriate capital structure should have the following features

 Profitability / Return

 Solvency / Risk

 Flexibility

 Conservation / Capacity

 Control

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Determinants of Capital Structure

 Seasonal Variations
 Tax benefit of Debt
 Flexibility
 Control
 Industry Leverage Ratios
 Agency Costs
 Industry Life Cycle
 Degree of Competition
 Company Characteristics
 Requirements of Investors
 Timing of Public Issue
 Legal Requirements

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Patterns / Forms of Capital Structure

Following are the forms of capital structure:
 Complete equity share capital;
 Different proportions of equity and preference share capital;
 Different proportions of equity and debenture (debt) capital and
 Different proportions of equity, preference and debenture (debt) capital.

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Problems on Capital structure

Fitwell company is now capitalized with Rs. 50,00,000 consisting of 10,000
ordinary shares of Rs. 500 each. Additional finance of Rs. 50,00,000 is
required for a major expansion programme launched by the company.
Four possible financing plane are under consideration. These are:
2.Entirely through additional share capital, issuing 10,000 shares of Rs.
500 each.
3.Rs. 25 lakhs through ordinary shares and Rs. 25lakhs through 12% debt.
4.Entirely through 13% debt.
5.Rs. 25 lakhs through equity and Rs. 25lakhs through 10% preference
shares of Rs. 500 each.
The company’s EBIT presently is Rs. 6lakhs. By virtue of the increase in
capitalization, the EBIT is expected to double the present level.
Examine the impact of financial leverage of these four plans and calculate
the EPS for the shareholders, assuming the tax rate to be 50%.
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Problems on Capital structure

• A company needs Rs. 12,00,000 for the installation of a new
factory, which would yield an annual EBIT of Rs. 200,000. the
company has the objective of maximizing the EPS. It is
considering the possibility of issuing equity shares plus
raising a debt of Rs. 200,000, Rs. 600,000 or Rs. 10,00,000.
The current market price per share is Rs. 40 which is
expected to drop to Rs. 25 per share if the market borrowings
were to exceed t 750,000.
• Cost of borrowings are indicated as under:
• Up to Rs. 250,000 10%p.a
• Between Rs. 250,001 and Rs. 625000 14%p.a
• Between Rs. 625,001 and Rs. 10,00,000 16%p.a
• Assuming tax rate to be 50% work out EPS in each case and
suggest the best option. Copyright © 2008, Dr Sudhindra Bhat

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Meaning of Financial Leverage

 The use of the fixed-charges sources of funds, such as debt and preference
capital along with the owners’ equity in the capital structure, is described as
financial leverage or gearing or trading on equity.
 The financial leverage employed by a company is intended to earn more
return on the fixed-charge funds than their costs. The surplus (or deficit) will
increase (or decrease) the return on the owners’ equity. The rate of return on
the owners’ equity is levered above or below the rate of return on total
assets.

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Measures of Financial Leverage

 Debt ratio
 Debt–equity ratio
 Interest coverage
 The first two measures of financial leverage can be expressed either in terms
of book values or market values. These two measures are also known as
measures of capital gearing.
 The third measure of financial leverage, commonly known as coverage ratio.
The reciprocal of interest coverage is a measure of the firm’s income gearing.

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Financial Leverage of Ten Largest Indian

Companies, 2006
Company Capital Gearing Income Gearing

Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio

1. Indian Oil 0.556 1.25:1 4.00 0.250

2. HPCL 0.350 0.54:1 5.15 0.194

3. BPCL 0.490 0.96:1 5.38 0.186

4. SAIL 0.858 6.00:1 - ve - ve

5. ONGC 0.106 0.12:1 53.49 0.019

6. TELCO 0.484 0.94:1 0.99 1.007

7. TISCO 0.577 1.37:1 1.62 0.616

8. BHEL 0.132 0.15:1 8.36 0.120

9. Reliance 0.430 0.75:1 3.46 0.289

10. L&T 0.522 1.09:1 2.31 0.433

11. HLL 0.027 0.03:1 264.92 0.004

12. Infosys 0.000 0.00:1 NA* NA*

13. Voltas 0.430 0.72:1 2.64 0.378

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Assumption of Capital Structure Theories

There are only two sources of funds i.e.: debt and equity.
 The total assets of the company are given and do no change.
 The total financing remains constant. The firm can change the degree of leverage
either by selling the shares and retiring debt or by issuing debt and redeeming
equity.
 Operating profits (EBIT) are not expected to grow.
 All the investors are assumed to have the same expectation about the future profits.
 Business risk is constant over time and assumed to be independent of its capital
structure and financial risk.
 Corporate tax does not exit.
 The company has infinite life.
 Dividend payout ratio = 100%.

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Net Income (NI) Approach
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 According to NI approach both the

cost of debt and the cost of equity are
Cost
independent of the capital structure;
they remain constant regardless of
how much debt the firm uses. As a
ke, ko ke
result, the overall cost of capital
declines and the firm value increases ko
kd kd
with debt.
 This approach has no basis in reality;
the optimum capital structure would be Debt

100 per cent debt financing under NI

approach.
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Net Operating Income (NOI) Approach
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 According to NOI approach the value

of the firm and the weighted average
cost of capital are independent of the
Cost
firm’s capital structure. ke
 In the absence of taxes, an individual
holding all the debt and equity
securities will receive the same cash ko

flows regardless of the capital kd

structure and therefore, value of the
company is the same.
Debt

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2 N DTRADITIONAL APPROACH CAPITAL
STRUCTURE
THEORY

Cost

ke

ko

kd

Debt

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MM Approach Without Tax: Proposition I

 MM’s Proposition I states that the firm’s value is independent of its capital
structure. With personal leverage, shareholders can receive exactly the same
return, with the same risk, from a levered firm and an unlevered firm. Thus, they
will sell shares of the over-priced firm and buy shares of the under-priced firm until
the two values equate. This is called arbitrage.

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MM’s Proposition II
 The cost of equity for a levered firm equals the constant overall cost of capital
plus a risk premium that equals the spread between the overall cost of capital
and the cost of debt multiplied by the firm’s debt-equity ratio. For financial
leverage to be irrelevant, the overall cost of capital must remain constant,
regardless of the amount of debt employed. This implies that the cost of equity
must rise as financial risk increases.

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MM Hypothesis With Corporate Tax

 Under current laws in most countries, debt has an important advantage over
equity: interest payments on debt are tax deductible, whereas dividend
payments and retained earnings are not. Investors in a levered firm receive in
the aggregate the unlevered cash flow plus an amount equal to the tax
deduction on interest. Capitalising the first component of cash flow at the all-
equity rate and the second at the cost of debt shows that the value of the
levered firm is equal to the value of the unlevered firm plus the interest tax shield
which is tax rate times the debt (if the shield is fully usable).
 It is assumed that the firm will borrow the same amount of debt in perpetuity and
will always be able to use the tax shield. Also, it ignores bankruptcy and agency
costs.

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